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What is NPV? What is IRR? What is the difference between NPV
and IRR method? Which and why among NPV and IRR do you think
is more appropriate technique in capital budgeting?
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Answer Posted / rudradeva
Key differences between the most popular methods, the NPV
(Net Present Value) Method and IRR (Internal Rate of Return)
Method, include:
• NPV is calculated in terms of currency while IRR is
expressed in terms of the percentage return a firm expects
the capital project to return;
• Academic evidence suggests that the NPV Method is
preferred over other methods since it calculates additional
wealth and the IRR Method does not;
• The IRR Method cannot be used to evaluate projects where
there are changing cash flows (e.g., an initial outflow
followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);
• However, the IRR Method does have one significant
advantage -- managers tend to better understand the concept
of returns stated in percentages and find it easy to compare
to the required cost of capital; and, finally,
• While both the NPV Method and the IRR Method are both DCF
models and can even reach similar conclusions about a single
project, the use of the IRR Method can lead to the belief
that a smaller project with a shorter life and earlier cash
inflows, is preferable to a larger project that will
generate more cash.
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